The SEC has lifted the lid on the conflicts of interest in the rating of subprime mortgage-backed securities

WASHINGTON, DC – The role of the big three rating agencies in providing subprime-based investments with flawed ratings is a contentious topic. Moody’s, Fitch and Standard & Poor’s have already suffered a desultory press and a good deal of mud slinging since the subprime dam burst last year. Long overdue questions have been asked as to what drove those ratings. Was it consistently faulty risk analysis, flawed a lack of information and false assumptions? Or was it the lure of fees obtained from issuers seeking the best rating before selling on their subprime-loaded investments, gladly accepted by rating agencies keen to gain ground in the shady business of what the industry called ‘ratings shopping’? These are muddy waters, containing few simple answers. But a long awaited and exhaustive report published by US regulator the Securities and Exchange Commission (SEC) this month has helped provide perhaps the clearest impression so far.

The report concludes that the credit rating agencies struggled with the growth in popularity of collateralised debt obligations (CDOs) and residential backed mortgage securities (RBMS). SEC investigators unearthed analyst emails, with one anonymously labelled example saying: “We do not have the resources to support what we are doing now,” with regard to RMBS ratings. Another, on the subject of CDO ratings, said: “Let’s hope we are all wealthy and retired by the time this house of cards falters.” That neglected house of cards did indeed collapse once market conditions deteriorated. Ken Swenson, a principle at risk management consultancy CRA, says: “At one time you could make a rating and renew it periodically every year, but the rating agencies have now found that not only is the efficacy and rigour of the ratings as they are given crucial, but also the necessity of on-going monitoring processes in place.”

The weight of the deluge of CDOs and RMBS placed on ratings analysts allowed for the weaknesses in the ratings process. However, what the SEC describes as the “issuer pays conflict” created the incentive to rate the greater volume of CDOs and RBMS rather than with rate them the greatest thoroughness. Of perhaps even greater significance, internal policies failed to prevent participants in the ratings analytical process from participating in fee discussions, effectively muddying the waters between ratings objectivity and profit. SEC chairman Christopher Cox heralded the release of the probe, saying: “There have been instances in which there were people both pitching the business, debating the fees and were involved in the analytical side.”

Investors, lacking alternative sources of information, had placed blind faith placed in credit ratings, lent legitimacy by regulatory use of ratings as reference points in capital adequacy regulation. To remedy this, the SEC has already released new rules in June set to allow markets to invest in short-term debt without regard to the agencies’ ratings. However, this only addresses part of the problem. If ratings must evolve from trusted opinions to sources of information, they must also become transparent. The need for disclosure of policies and transparency of the information which informed ratings represents a key message of the SEC paper.

But has the regulator gone far enough? “The SEC should be commended for stepping up to the plate and reining in the situation. They have made this investigation a priority,” says Swenson. The report concludes by saying the agencies are cooperating to improve their practices, policies and procedures. New York Attorney General Andrew Cuomo has pioneered many of the reforms aimed at the rating agencies and at the other players tainted by subprime. Most of those changes were brokered under the threat of legal action. Many of the embarrassing emails and internal governance flaws uncovered by the SEC could also form bases for legal challenges by those seeking to apportion blame. The SEC says its report has been completed under statutory authority from Congress, and it is from the Capitol that punitive measures may yet come.

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